Markets: You pay your money and take your chance

There's a battle developing in the bond market between Goldilocks and the bears, with European investors split on the outlook for German and US interest rates.

Fans of US bonds are convinced the world's largest economy will continue to bask in a "Goldilocks" scenario, with Federal Reserve Chairman Alan Greenspan last week reinforcing the view that the economy is running neither too hot, nor too cold, but just right, with strong growth not endangering low inflation.

However, those enthusiasts warn that economic growth in Europe may rebound in the coming months. That may fuel inflation and prompt a rise in official interest rates from the German Bundesbank, sending European bond yields higher.

Others, however, expect US growth to kindle higher prices in the months ahead, spurring the Fed to raise rates even as the efforts of European governments to meet the Maastricht criteria mean economic growth on

the Continent remains lacklustre.

The dispute highlights how the much-vaunted "new paradigm" is making the job of economists and fund managers much tougher, as technological advances and improved productivity blunt the tools usually used to assess the state of the global economy.

With no consensus on the likely temperature of the US economy in the months ahead, it's harder for European investors to decide whether to stick their money in European bonds or Treasuries in the second half of the year.

"There's some value in longer US securities versus Dutch bonds from 10 years out," said Hans Grundeken, head of bonds at Kempen & Co in Amsterdam. "Since I believe the dollar will get stronger, you get 75 basis points more just for free. There's still value in Treasuries because the US currency is so strong."

In dollar terms, the 4.6 per cent return so far in 1997 on US bonds maturing in more than one year beats anything an investor could have on European bonds in any maturity, excluding the UK market.

With European politicians showing their willingness to bend the Maastricht rules on budget deficits to keep the euro timetable on track, there's scant prospect of European currencies staging a recovery. "European currencies should remain relatively weak against the dollar," is the view of Roman Gaiser, an economist at Louis Dreyfus Finance Banque in Paris.

Investors currently demand a premium of about 70 basis points to buy US 10-year debt rather than equivalent German bonds. US securities yield an annualised 6.25 per cent, compared with 5.55 per cent in bunds.

That spread, a measure of the additional risk investors perceive in Treasuries, is down from more than 90 basis points a month ago and from 100 two months ago.

Mr Greenspan gave Treasuries a further boost last week when he described the US economy as "exceptional," while his fellow Fed member Laurence Meyer said the performance of the economy is "enough to make you want to cheer".

While that was enough to smother any lingering concerns that the US central bank was poised to raise interest rates, some fund managers remain wary of a rebound in the US economy which would spoil the porridge.

"We fear that third-quarter US growth will be higher than in the second quarter," said Edith Siermann, who has stopped buying Treasuries and is stocking up on German bonds instead for Rotterdam-based Robeco. "Even if inflation is improving, cyclical pressures should build up one way or another."

In Germany, meanwhile, the Bundesbank has held interest rates at historic lows since August last year when it cut its securities repurchase rate to 3 per cent.

The German central bank spooked some bondholders last week when it set interest rates for just two out of the four weeks it is supposed to be on holiday, opening the door to a rise in interest rates in early August if it decides it has had enough of the mark falling against the dollar. Its chief economist, Otmar Issing, went as far as warning traders that "we aren't on vacation" as far as the currency market is concerned.

Nevertheless, with the pan-German economy growing just 0.4 per cent in the first quarter, some fund managers reckon the Bundesbank will be loath to risk pushing the economy back into recession by tightening monetary conditions, making bunds the better investment in the coming months. "There'll be no specific changes in policy from the Bundesbank," said Rod Davidson of Murray Johnstone International. He's stocking up on 10- and 30-year bunds and sees German debt outperforming the US in coming months.

The spread with Treasuries "will probably begin to widen again. The growth prospects are completely different; Germany's at a different stage from the US economy," Davidson reckons. If the German central bank continues to stand pat on rates, bunds should outperform Treasuries, investors said.

"We don't think rates will rise for the rest of the year," said Siermann at Robeco Group. "We see some growth coming through with the weakening of the mark but growth won't be too fast in bond market terms."

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